European funding sows seeds of next crisis

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The European Central Bank's second long-term repo operation is in the books now, and no matter what cognoscenti may say about whether it was a bigger or smaller number than expected, the fact of the matter is that some 320 billion euros were created out of thin air and dumped into the European economy in a single day.

Around 800 banks participated in the quantitative easing with a continental twist, borrowing money at 1% for three years with virtually any sort of collateral.

I know that we get a little jaded from time to time, but that is a lot of money -- mucho dinero, big kwan, a whole lotta lettuce, a smokin' stack of simoleons -- and especially all at once.

This credit splash is supposed to prevent a funding blowup for the ailing banks and states in the euro zone, but veteran analysts are also pointing out that it kicks the potential cost up to disastrous levels if the underlying causes of the crisis in the region drag on through mid-decade.

So far the wizard behind this magical mountain of money, rookie ECB chief Mario Draghi, has won praise from colleagues and academics that he acted just in time to avert a contraction of the money supply and a banking catastrophe, giving banks and governments time to recover.

The cheap loans are now widely expected to help sprout a wide economic recovery in Europe by the end of the year even though governments are paring budgets to the bone to meet austerity targets. Think of the money as Novocain administered for a very difficult operation on a live patient.

You can see the difference dramatically by observing the value of the new PowerShares exchange traded funds tracking super-risky Italian bond futuresITLY
and supersafe German bond futuresBUNL
The former are up 16% this year, while the latter are flat.

And yet there is no pranzo libero, or free lunch, in economics, even in Rome, so there are without doubt unexpected and dangerous consequences lurking on the horizon. The ECB has acted unilaterally without any rules or precedence, so policy makers are making it up as they go along.

Ambrose Evans Pritchard, international economics columnist at The Daily Telegraph in London and a euro skeptic from way back, observed that Spanish banks used the first LTRO to boost holdings of sovereign debt by 29% to 230 billion, and just about the same occurred in Italy. If you think about it a minute, he argues, what has happened is that the weakest banks are buying the weakest government bonds in volumes that exceed their equity base. The columnist quoted a credit strategist at RBS as stating, "It is a levered option on sovereign risk."

Well if you put it that way, yeah, that could be a problem. Banks have to provide the ECB with collateral at a sizable discount to their value, which eats up some of their balance sheet. Since the ECB would have a first claim on those assets in case of trouble, other creditors are pushed down in rank. Essentially anyone who has lent money to those banks is now subordinated to the ECB, which means that in a bankruptcy a banks' bondholders could get bupkis.

In this light, you can see that the line between the real economy and the government-supported economy has been stretched very thin. The ECB's backdoor bailout of insolvent euro zone states will absolutely make matters much worse if policy makers cannot use the next three years to get the region's economy back on its feet. You could easily imagine a real contagion develop in which sovereign debt defaults bring down countries one after another like dum-dum dominoes.

The upshot is that this is a money-laundering scheme with an asymmetrical risk profile. The banks borrow from the ECB to buy government debt, which is then used as collateral to borrow more money from the ECB. This gets around ECB rules against money printing. Yet it ignores the fact that banks have to be browbeaten to take southern euro zone government debt because it is risky. So the more debt the ECB bullies banks into owning, the riskier it is making banks' conditions.

The whole gambit is a gigantic, trillion-euro bet that banks will lend the new funds wisely, helping their economies to flourish, which will create the taxes necessary to service the debt on all these loans. I hope it works. But if that doesn't happen — and frankly, it has not happened in the past three years — watch out. Not even Germany and France will be immune to the fallout.

It is important to realize is that creating money and initial confidence is the easy part. The hard part is forcing banks to lend the funds judiciously and generously to deserving, ambitious entrepreneurs, and for those borrowers in turn to generate valuable new business. Unfortunately the history of cheap money is that lenders and businesses tend not to value it properly, and much is hoarded, spent on banker bonuses, wasted on bad loans, and recycled back to government officials via corruption.

So while the LTRO has juiced hopes for a while that the global financial system won't fall apart in the first half of 2012, it is now up to all those other policy makers and business leaders to prevent it from becoming one more failure of technocrats trying to plan the global economy from the center.

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